Derivatives-chp9,10,11.docx

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School

University of Toronto Scarborough

Department

Finance

Course

MGFC30H3

Professor

Jason Wei

Semester

Winter

Description

Chapter 9­ Mechanics of Options market
Types of Options
Call Option­ The right to buy
Put Option­ The right to sell
Expiration Date­ The date specified on the contract
Exercise Price (strike price)­ The price specified on the contact
American Option­ can be exercised at any time within the expiration date
European Option: can be only exercised at the expiration date
Most options traded are American, but European options is analyzed for its simplicity
Call Options
• Exercise when stock price is above strike price
Put Options
• Purchaser hopes that the stock price will decrease to earn a profit
Options Positions
• There are two positions in options: short and long
• Long is when the investor purchases the call option
• Short is the position which the investor sells or writes the option
o Writer of the option receives cash up front but has potential liabilities later
• Writer’s profit/loss is the reverse of the purchaser
Underlying Assets
• Stock Options
o The most traded on the exchange
o One contract gives the holder the right to buy or sell 100 shares at a specified strike price
• Foreign Currency Options
o Mostly traded in the OTC market
o One contract buys/sells 10 000 units of foreign currency
• Index Options
o Traded all over the world in OTC and exchange traded market
o Most popular contracts: S&P 500 Index, S&P 100 index, Nasdaq, and Dow jones
o One contract is to buy/ sell 100 times the index at the specified strike price
• Future Options
o Exchange trades that are traded in a future contract
o Often matures just before the delivery period in the futures contract
Specification of Stock Options
• Expiration Dates
o Precise expiration date is the Saturday immediately following the third Friday of the expiration
month
o The last day of the trade is the third Friday of the expiration month
o Stock options in US have January, February and March cylces
o January cycle­ January, April, July, and October
o February­February, May, August, November
o March Cycle­ March, June, September, December
• Strike Price
o Strike are spaced by $2.5, 45, or $10
o When a new expiration date is introduced, two or three strike prices closest to the current stock
price is selected by the exchange
o Ex. If current price is $84, they will offer $80.$85,$90 as strike prices
• Terminology
o Option class: All options of the same type (call or put)
o Option Series: options of a given class with same expiration date and strike price
o In­the money: gain o Out the money: lose
o At the money: equal
o Intrinsic Value: the maximum of zero and the value the option would have if it were exercised
immediately
Flex Options
o Options traded with non­standard terms
o Different expiration or strike price compared to the exchange
Dividends and Stock Splits
o When a cash dividend occurs, there is no adjustments to the terms of the option contract
o Exchange traded options are adjusted for stock splits
o Stock split will cause stock price to go down
Position Limits and Exercise Limits
o Position Limit: the maximum number of options contract that an investor can hold on one side of the
market (long calls & short put are the same side)
o Exercise Limit: it is the position limit and it is the maximum number of contracts that can be exercised
by any individual in any period of 5 consecutive business days
Market Maker
o A market maker is an individual who or when asked to, provides the bid or offer quote of an option
o They ensure that buy and sell orders are executed at some prices without delays
o They add liquidity to the market and make profits off bid­ask spreads
Offsetting Orders
o An investor who has purchased options can close their position by issuing an offsetting order to sell the
same number of options
Commissions
o Commission vary between different brokers, some charge at a discount (discount brokers) and offer
limited services
o The commission is often calculated as a fixed cost plus a proportion of what was traded
o There are hidden costs within the Bid­Ask spread
Margins
o Buying on Margin: one borrows from the broker to purchase shares (up to 50%)
o Margin Call: the broker requests money to be deposited
o Call and put options with maturities less than 9 months, the option price must be paid full
o Investors cannot buy these options on margin because it will increase the leverage even more
o Options with maturities greater than 9 months can be bought on margin up to 25%
Writing Naked Options
o Naked Option: an option that is not combined with an offsetting position in the underlying stock
o The initial and maintenance margin required by the CBOE for a written naked call option is the greater
of the following 2 calculations:
1. A total of 100% of the proceeds of sales plus 20% of the underlying share price amount, if any, by
which the option is out of money
2. A total of 100% plus 10% of the underlying share price
o For a written naked put option, it is the greater of:
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the
amount, if any, by which the option is out of the money
2. A total of 100% of the option proceeds plus 10% of the exercise price.
The Option Clearing Corporation
o The OCC guarantees that the option writers fulfill their obligations under the under the terms of options contracts and keeps all records of long and short positions
o All option trades must be cleared through an OCC member, if a broker is not a member, they
must arrange to clear the trade with one
o The writer maintains a margin with the broker and the broker maintains a margin with the OCC
member who clears the trades
Exercising an Option
o When investor notifies a broker to exercise an option, the broker in turn notifies the OCC
member that clears its trades
Taxation
o Gains and losses from stock trade are taxed
o Gain/loss is recognized when:
o The option expires unexercised
o The option position is closed out
Wash Sale Rule
o Investors who repurchase stocks within 30 days of the sale, any loss on the sale cannot be
deductible
Warrant, Employee Stock Option, and Convertibles
o Warrants: options issued by financial institutions or non financial corporation
o Employee Stock Options: call options issued to employees by their company to motivate them to
act in the best interests of the company’s shareholders
o Convertible Bonds: bonds issued by a company that can be converted into equity at certain times
using a predetermined exchange ratio
Chapter 10-Properties of Stock Options
FactorsAffecting Option Prices
o 6 factors that affect the price of stock options
o The current stock price, So
o The strike price, K
o The time of expiration, T o The volatility of the stock price, O
o The risk free interest rate, r
o The dividends that are expected to be paid
o Summary of the effect on the price of a stock option of increasing one variable while all others
are fixed
o
Stock Price and Strike Price
o Call options are valuable when the stock price exceeds the strike price, vice versa with put
options
Time of Expiration
o The put and call options are more valuable in the American option with the time of expiration
increases
o This case is usually the same with European call and put option except when dividends are
declared
Volatility
o Volatility of a stock price is a measure of how uncertain we are about future price movements
o When volatility increases, stock can either do very well or very poor
o Value of volatility for call and put increases as volatility increases as well
Risk Free Interest Rate o Risk free interest affects the price of an option indirectly
o When interest rates increase in an economy, this means that the expected return for investors
increase as well
o Present value (when interest increases) of all future cash flow will decrease
o Combined impact results in increase value for call option and decrease value for put
option
o When interest rates rise (fall), stock prices fall (rise)
Amount of Future Dividends
o Dividends have the effect of reducing the stock price on the ex-dividend date
o This is bad for call options and good for put options Upper and Lower bounds for Option Prices
o Upper Bound
o American/European call option gives holder the right to buy/sell the stock for a certain
price
o Option can NEVER be worth more than the stock
o The Stock price is the upper bound to the option price
 C